Option Investor
Educational Article

The Put Write

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Nothing is more frustrating than waiting for a stock to drop to your limit and never getting the transaction filled. This practice goes on just about everyday in the world of trading. The dreaded "limit" order to buy, at a price lower than the current market value.


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Well, suppose I told you that someone would pay you to wait for your stock to drop to the price you would like to own it, and that if it never dropped to that predetermined price, you'd keep the money that they paid you to wait. You're probably saying," What have you been drinking Steve!" but alas! The strategy that I am going to show you does exactly that. It has someone pay you to wait for your limit order to get filled. This strategy is called "Put writing". To show you why it is a more effective strategy than using a limit order, I would like to set up a scenario comparing the "Limit order" to the "Put write". Let's begin with a basic strategy statement. This strategy is used when you are looking to purchase a stock at a cheaper price then it is currently selling for in the market. The intend of this strategy is that you would like to own the stock at this lower price. Important, your intend is to own the stock! Now let's say a hypothetical stock called FGH were selling at 49.50 and we thought it was a great company, but 49.50 at this time was just a little too much to pay. But if we could get it for $45 a share, man would that be a steal! So in our scenario we could put in a limit order to buy FGH at $45 if it drops down to that level or we could utilize a little strategy called the "put write" that would be a little more economically beneficial no matter what the stock did. So let's say instead of just putting in the limit order to buy the stock at $45, we instead sold a June FGH $45 put for $1.75 or $175 for each 100 shares we wanted to eventually purchase. So our comparative scenarios would look like this (see Figure 1 below)

Option #1: A limit order to buy FGH at $45.

Versus

Option #2: The selling of a FGH June $45 put for a net credit of $1.75 or $175 per 100 shares.

Now given the two options above, the market in terms of scenarios can only do 1 of three things.
1. Go down
2. Stay the same
3. Go up

Let's look at what happens with each of these scenarios.

Scenario #1: The market goes down.

If the market goes down and FGH goes to $45, your limit order goes off and you get the stock at a price of $45 a share. That was your intend, Right!

However, in option #2: You get 100 shares of FGH put to you at the price of $45, but remember you received $175 or $1.75 a share for the put option that you sold. So in option #2, you actually get the FGH stock for a net cost of $43.50. That is $45 a share minus the $1.75 a share you received for the put option. Hence, you spend $1.75 a share less to own the same stock as if you just used a limit order. But you now say, what happens if the stock goes to $30! Sure you are losing money, but let's compare apples to apples. No matter how low the stock goes remember the intent of the transaction, you wanted to OWN this stock and no matter how low it goes you will still have paid $1.75 less per share by using the "put write", then if you just used the "limit order"


Scenario #2 and #3: The stock stays the same or the stock goes higher.

They are both the same. Here's why. If FGH never goes down or goes up, your limit order will never be executed. Hence, you do not get the stock and in fact you get nothing but a waste of your time hoping the stock would have gone down. However, with option#2, even if the stock stays the same or goes up, you still keep the $1.75. Remember with the limit order you would have never gotten the stock, but at least with the "put write", you receive a premium credit of $175 for every 100 shares. "Sort of like getting paid while you wait for the stock to come down to your price." In addition, you can "sell another put" when your put expires. This becomes really interesting if the stock hasn't moved down much, but really interesting if the stock has moved down close to your asking price. You can get more of a premium when you sell the FGH July $45 put if the stock is less then $49.50 but not quite $45. When you compare all the scenarios, you can see how the put write is the better option (no pun intended) then the limit order. whether the stock goes up, down or stays the same.

 

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